Types of Inventory Costs:

There are mainly three types of Inventory costs:

(i) Holding cost

(ii) Shortage or stock-out cost

(iii) Set-up cost

1. Holding Cost (C1 or Ch):

The cost associated with carrying or holding the goods in stock is known as holding cost or carrying cost which is usually denoted by C1 or Ch per unit of goods for a unit of time. Holding cost is assumed to vary directly with the size of inventory as well as the time for which the item is held in stock.

The following components constitute the holding cost:

(i) Invested Capital Cost.

This is the interest charge over the capital investment. Since this is the most important component, a careful investigation is required to determine its rate.

(ii) Record Keeping and Administrative Cost.

This signifies the need of keeping funds for maintaining the records and necessary administration.

(iii) Handling Costs.

These include all costs associated with movement of stock such as: cost of labour over-head cranes, gantries and other machinery required for this purpose.

(iv) Storage Costs.

These involve the rent of storage space or depreciation and interest even if the own space is used.

(v) Depreciation, Deterioration and Obsolescence Costs.

Such costs arise due to the items in stock being out of fashion or the items undergoing chemical changes during storage (e.g. rusting in steel).

(vi) Taxes and Insurance Costs.

All these costs require careful study and generally amounts to 1% to 2% of the invested capital.

(vii) Purchase Price or Production Costs.

Purchase price per unit item is affected by the quantity purchased due to quantity discounts or price-breaks. Production cost per unit item depends upon the length of production runs. For long smooth production runs this cost in lower due to more efficiency of men and machines. So the order quantity must be suitably modified to take the advantage of these price discounts. If P is the purchase price of an item and I is the stock holding cost per unit item expressed as a fraction of stock value (in rupees), then the holding cost C = I P.

(viii) Salvage Costs or Selling Price.

When the demand for an item is affected by its quantity in stock, the decision model of the problem depends upon the profit maximization criterion and includes the revenue (sales tax etc.) from the sale of the item. Generally, salvage costs are combined with the storage costs and not considered independently.

2. Shortage Costs or Stock-out Costs (C2 or Cs):

The penalty costs that are incurred as a result of running out of stock (i.e., shortage) are known as shortage or stock-out costs. These are denoted by C2 or Cs per unit of goods for a specified period.

These costs arise due to shortage of goods, sales may be lost, and good will may be lost either by a delay in meeting the demand or being quite unable to meet the demand at all. In the case where the unfilled demand for the goods can be satisfied at a latter date (backlog case), these costs are usually assumed to vary directly with the shortage quantity and the delaying time both.

On the other hand, if the unfilled demand is lost (no backlog case), shortage costs become proportional to shortage quantity only.

3. Set-up Costs (C3 or Co):

These include the fixed cost associated with obtaining goods through placing of an order or purchasing or manufacturing or setting up a machinery before starting production. So they include costs of purchase, requisition, follow-up, receiving the goods, quality control, etc. These are also called order costs or replenishment costs, usually denoted by C3 or Co per production run (cycle). They are assumed to be independent of the quantity ordered or produced.

(Source – Various books of college library)

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